Dealpolitik: Why It’s Hard to Successfully Sue Your Banker

On Wednesday, a jury in Boston found that Goldman Sachs Group Inc. had no liability to the owners of its former client, Dragon Systems. Goldman had advised closely held Dragon on its approximately $600 million sale to Lernout & Hauspie Speech Products N.V. The case is an important reminder for investment banking clients that even if they think their bankers made a mistake, the banker will probably have no liability.

The problem for the Dragon shareholders was that the purchase price they received was paid entirely in Lernout shares and the Dragon shareholders were able to sell only a small portion of them before the crisis hit. A couple a months after the closing of the transaction, a Journal article reported that some of the Asian entities Lernout claimed as customers said they did not do business with Lernout. Within six months of Lernout’s purchase of Dragon, the Lernout audit committee found that a large amount of its income had been improperly recorded and a few days later Lernout filed for bankruptcy. The former Dragon shareholders, who had traded their Dragon shares for Lernout shares, were almost completely wiped out.

Goldman advised Dragon on the deal. The Dragon shareholders who lost virtually everything to the Lernout fraud in lawsuits blamed Goldman and sued the bank for their losses. Goldman denied the allegations and successfully argued that the two principal selling shareholders were to blame in their rush to do a deal and that they had breached their duties to other shareholders.

The jury turned the former Dragon shareholders down in its Wednesday verdict. The verdict should not be a big surprise as it is almost always extremely difficult for an investment banking client to win a lawsuit against its bank.

That is because investment banks work on M&A assignments pursuant to “engagement letters” which set out the scope of the bankers’ work, the fees they will be paid (in the case of Dragon, Goldman earned a $5 million fee for completing the sale), and most significantly here, the bankers’ protections from legal liability.

The Company [and others] also agree that neither Goldman Sachs nor any of such affiliates, partners, directors, agents, employees or controlling persons shall have any liability to the Company, [or other parties] or any person asserting claims on behalf of or in right of the Company in connection with or as a result of either our agreement or any matter referred to in this letter except to the extent that any losses, claims, damages, liabilities, or expenses incurred by the Company result from the gross negligence, willful misconduct or bad faith of Goldman Sachs in performing the services that are the subject of this letter.

In other words, engagement letters provide that the banker is off the hook unless it engages in bad faith, willful misconduct or “gross negligence.” Those are standards of conduct bankers ought to be able to easily meet. Merely making a mistake or being negligent—which means failing to exercise ordinary care—does not make a banker liable.

Virtually all engagement letters also provide an indemnity to the investment bank from the client, which means the client will reimburse the banker if it has any liability, subject to the same three carveouts (willful misconduct, bad faith and gross negligence).

So even if the standard of responsibility for Goldman had been ordinary (rather than gross) negligence in the engagement letter, that might not have made a difference, as Goldman raised questions as to who bore the responsibility for missing Lernout’s problems.

But stepping back, the case is still a lesson that no matter how much a client may be relying on its banker in an m&a deal, the client should not expect any liability on the part of the banker except for extreme behavior on the banker’s part.

Lawyers for corporate clients would undoubtedly try for such protection too (and they do in other countries) but it is generally not ethical for U.S. lawyers to seek from their clients exculpation or an indemnity for the negligence of the lawyer.

Should we expect investment banking engagement letters to change following the Dragon case? That is unlikely. Goldman’s $5 million fee was less than 1% of the purchase price. Things go wrong in many deals (although generally in less extreme ways than the Lernout collapse). Bankers are concerned that accepting liability for ordinary negligence will turn them into insurers of deals. Even competitive pressure to get business will be unlikely to lead bankers to take responsibility for anything short of extreme conduct such as bad faith or gross negligence.

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Deal Journal is an up-to-the-minute take on the deals and deal makers that shape the landscape of Wall Street, including mergers and acquisitions, capital-raising, private equity and bankruptcy. In short, wherever money changes hands. Deal Journal is updated throughout each trading day with exclusive commentary, analysis, data, news flashes and profiles. The Wall Street Journal’s David Benoit is the lead writer, with contributions from other Journal reporters and editors. Send news items, comments and questions to deals@wsj.com.